What’s Behind The Drop In FDI?

You may have heard that inward FDI to Malaysia crashed in 2009 – Tony Pua has a nice roundup on his blog. You can read the full report from UNCTAD here.

As far as knowing the cause, I haven’t a clue…yet. There is of course the general drop in FDI across the globe in 2009 due to the global recession, but that doesn’t explain why Malaysia’s inward FDI dropped more than most. There’s also some interesting anomalies with the data that I really would want to know about before commenting on the situation, such as the massive increase (like, 100%+ a year) in both inward and outward FDI stocks from 2007-2009. This isn’t something that is confined to Malaysia – it runs across the global database.

As far as suspecting why inward FDI has been so poor lately, however, I have a few ideas.

First is the meme that both foreign companies and Malaysian companies are finding Malaysia less attractive as an investment destination. There’s more than a grain of truth here – outward FDI from Malaysia has been a feature of capital flows for the last decade (see my post here). This is indisputable.

However, I’m less inclined than most to put this down to a lack of competitiveness vis-a-vis our regional peers like Thailand, and less developed countries like Vietnam, Cambodia and the Philippines. In economic theory, capital will flow to where returns are highest. Leaving aside why this doesn’t always happen empirically, this suggests that inward investment will be highest where capital stock is low relative to the economy – which would explain why there continues to be interest in, for example, Indonesia and Vietnam (and India for that matter), where production continues to be fairly labour intensive but institutional development has progressed far enough that investors are faced with a falling risk premium. Capital deepening in those countries would generate higher returns as labour use of capital expands. FDI is in this case useful to bolster insufficient domestic savings (yes, even with a high savings rate) to finance capital investment.

The implication is of course that our level of capital stock is already high enough that additions to the stock of capital would generate relatively lower returns. And our stock of savings is also already sufficiently high to finance whatever investment we need, which means incoming FDI is actually superfluous to requirements. I’ll return to this issue at the end of the post.

The situation with respect to Thailand and Singapore require different explanations. Singapore’s is the easiest – despite all the efforts of SC and BNM, Singapore remains the financial centre of the region with M&A activity mainly flowing through the city-state’s well developed financial sector. Our only advantage in this arena is in Islamic finance – but that’s just as likely to involve capital outflows as inflows.

Thailand on the other hand has a definite structural advantage – it has a far bigger domestic market than we have. This I’ll put down as a decades old mistake in policy, as I outlined in this post on South-East Asian demographics (excerpts):

When other countries in the region began actively trying to restrict population growth after the 1960s, Malaysia only paid lip service to the idea then went the other direction with the 1984-85 National Population Policy. If you aren't old enough to remember this, the goal was to increase the population to 70 million by 2100 - with lots of accompanying jokes about encouraging polygamy, natch.

As a result, we are far behind the curve in getting into stage 3 of the demographic transition compared to our regional peers…

…Note the substantial difference in age structure between the Asian Tigers and the other three countries shown here. Also, Malaysia appears to be behind even Indonesia in starting the stage 3 demographic transition…

…Malaysia will have the same population median age in 2050, that Singapore had in 2000! This explains a lot of why Malaysia has lagged the Asian Tigers in growth - imagine a 2% disadvantage in per capita income growth every year, for a whole generation. On that basis, it's actually more surprising we are a middle-income country at all, as our population age profile is more typical of a stage 2 low-income economy.

The implication is also that Malaysia's growth potential over the next couple of decades is far higher than most of the region - apart from Indonesia, the rest of the economies in this (unscientific) sample will be subject to rapid population aging after about 2015. But the key to realizing that growth potential of course is putting in place the correct policies to take advantage of the demographic dividend when it comes.

Thailand (and Indonesia for that matter) not only have bigger populations, but they also have a bigger proportion of their population in the working age brackets, and that situation will persist for at least another couple of decades.

I’ll also reference this article I linked to in a post I made last week:

The index focuses on exports and comparative advantage, so we’re not talking about other aspects of development here. The results are interesting: among non-high income countries, we’re ranked first in export sophistication but near the bottom in potential for further structural change; about average in terms of diversification, but low on the scale of standardisation (which means less competition).

Indonesia and Thailand rank higher in terms of export diversification and potential for structural change i.e. there’s greater potential for returns from capital investment. Malaysia already ranks very high in terms of export sophistication (in fact tops among non high income countries), which suggests to me that we already have a high degree of capital intensity in export production.

Which leads me to my last point, which ties in all the factors above. I seriously believe that we’re still in a state of over-capacity in certain segments of the economy such as manufacturing. That means further investment would only be adding to idle capacity, which obviously isn’t that attractive to foreign investors unless we’re talking about diversification beyond our existing industries. We also (I suspect) are nearing saturation point in terms of both residential and commercial property, except at the very low end – ratios of housing and commercial property stock relative to the population have risen over the past decade. Given the abundance of domestic sources of financing, that means returns generated by FDI which are already depressed by over-capacity, has to also compete with domestic capital for investment worthy projects thus putting even more downward pressure on returns.

Under those conditions, it’s no surprise that inbound FDI is drying up and outbound FDI is becoming more prevalent. So what are the policy options, since we need investment to sustain economic growth? The key thing I think is to encourage further diversification in the economy, both external and domestic (you’re not going to be able to do much about the demographic situation). And also investment in “soft” assets like education and healthcare rather than hard assets like property development, other than infrastructure investment.

I’m sure inward (and outward) FDI will recover this year from last year’s trough – but we should start asking questions about what kind of FDI we’re getting.